The Credit Crunch and the Great Recession (Wonkish)

Ben Bernanke argues in a new paper that credit market disruption was the big story of the Great Recession.CreditCreditMinh Uong/The New York Times

OK, this is weird. There’s an economic dispute underway about the causes of the Great Recession — but that’s not what’s weird. What’s so strange in these days and times is that it is being carried out among well-informed people who actually look at data and argue in good faith. Hey, guys, don’t you know that sort of thing went out a couple of decades ago?

Anyway, on one side you have Dean Baker, who has long argued that the burst housing bubble was the main factor in both the slump and the slow recovery, with financial disruption a minor and transitory factor — a view I mostly agree with. On the other side we have none other than Ben Bernanke, who argues in a new paper that credit market disruption was indeed the big story.

This isn’t quite a head-on debate, since Bernanke is mainly focused on the first year or so after Lehman, while both Baker and I are more focused on the multiyear depressed economy that lasted long after the financial disruption ended. (Bernanke’s measures show the same spike and fast recovery as other stress indexes.) But there’s still a clear difference.

Unfortunately, I won’t be at the Brookings panel where Bernanke’s paper is discussed. But maybe I can raise the big question I have about his conclusions.

What Bernanke does is, as I see it, a kind of reduced-form analysis, identifying factors in the credit markets and using time series to estimate their impact on output. What Baker does, and I largely follow, is more of an accounting-based structural analysis: look at the components of aggregate demand, and ask what their behavior seems to imply about causes. In principle, these approaches should be consistent.

My problem with Bernanke’s paper, on a first read, is that I don’t quite see how that consistency can work. Specifically, I have trouble seeing the “transmission mechanism” — the way in which the financial shock is supposed to have affected actual spending to the extent necessary to justify a finance-first account of the slump.

Let me focus specifically on investment, which is what you’d expect a credit crunch to depress — and which did indeed plunge in the Great Recession. First, there was the housing bust, which led to a huge decline in residential investment, directly subtracting around 4 points from GDP:

Image

Figure 1CreditFederal Reserve of St. Louis

So can we attribute this decline to credit conditions? If so, why did residential investment remain depressed five years after credit markets normalized?

Meanwhile, there was also a sharp decline in nonresidential, i.e., business investment:

Image

Figure 2CreditFederal Reserve of St. Louis

But this decline was only about the same size as the decline in the early 2000s slump — which, admittedly, was partly because of the collapse in telecom spending, but still. And it seems pretty easy to explain simply by the accelerator effect: business investment always plunges when the economy is shrinking, which it was doing mainly because of the housing bust.

So when I look at these two key drivers of the Great Recession and subsequent depressed period, I don’t see an obvious role for financial disruption. Bernanke’s VARs tell a different story; but I generally don’t trust VARs unless I can relate them to phenomena we see from other perspectives.

Could Bernanke be right while Baker and I are wrong? Of course. But I really, really want to see the transmission mechanism.

Paul Krugman has been an Opinion columnist since 2000 and is also a Distinguished Professor at the City University of New York Graduate Center. He won the 2008 Nobel Memorial Prize in Economic Sciences for his work on international trade and economic geography. @PaulKrugman